The Moral Hazard of Central Banking

Virtually all economists agree on the proximate cause of the current financial world crisis: institutionalized moral hazard in the financial industries. Banks and other firms operating as financial intermediaries have a tendency to behave irresponsibly. They display an exuberant bias in their investment decisions, often taking risks out of proportion with possible returns on investment. Most notably they have reduced their equity ratios to extremely low levels, typically to less than ten percent. Equity being the economic buffer for losses, it follows that financial firms are more vulnerable the smaller their equity ratio. If such vulnerable firms dominate the market, there is an increased likelihood of contagion, as the liabilities of any one firm are usually the assets of other financial firms. The bankruptcy of just one sufficiently large firm can then trigger a domino effect of subsequent bankruptcies. The entire financial market melts down.

While economists agree on this basic fact, they disagree about its causes and remedies. Some seem to believe that the bias toward irresponsible investment decisions is a fact of nature such as bad weather and death. Financial markets are unstable by their very nature because the agents on these markets profit from superior knowledge as compared to their customers and therefore can enrich themselves at the expense of the latter.

While this theory is very widespread, it lacks any foundation in fact. If financial agents really had a bias to rip off their customers, there would soon be no clientele for them. Common people might be less informed than their bankers about the technicalities of financial instruments and investment strategies, but they can read a bottom line. They can also compare bottom lines and abandon their agent if they feel other people might take better care of their money.

The true cause of moral hazard in the financial sector is to be seen elsewhere, namely, in monetary policy and especially in the current monetary system.

Central banks function as lenders of last resort, that is, they lend money to financial firms and others who are unable to find creditors on the market. The salient point is that they can provide this service without any technical or economic limitations. Indeed, the money they lend does not cost them anything at all. Central banks do not have to borrow money; rather they make the money of the nation. Because paper notes are virtually costless to make, it follows that the amount central banks can lend is basically unlimited. This allows them not only to provide virtually unlimited credit to governments and similar institutions, but also to bail out market participants on the verge of bankruptcy. Thus they can prevent financial contagions and meltdowns.

At first sight, it appears that the activity of central banks is wholly beneficial. However, the exact opposite is the case. The problem is that the financial firms know that the central banks are there to help them out in times of trouble. They know that these institutions can make and lend as much money as they wish, at any price they wish, without being subject to physical or economic constraints. As a consequence, financial agents have the incentive to reckon with this kind of assistance. Rather than making their business plans and investment decisions in a responsible way, relying on other people only through contracts and other voluntary agreements, they now rely on publicly sponsored bailouts.

Who pays for such bailouts? Not the customers of the banks and other financial agents. Rather, these groups belong to the net beneficiaries of this policy. The true paymasters are citizens as a whole, in their capacity as money users. Bailouts through monetary policy always involve increases in the money supply. Money prices then tend to increase beyond the level they would otherwise have reached, and thus the purchasing power per unit of money is diminished below the level it would otherwise have reached. The real cash balances in the pockets of the citizens shrink, as do the real incomes of all people. Of course financial agents and their customers share this kind of loss, because they too are money users. But they pay only a part of the total bill. The rest is imposed on the rest of society.

To sum up, bailouts through monetary policy socialize the costs of bad investment decisions. This creates a moral hazard on the side of all the beneficiaries. Financial agents can worry less about risk and concentrate on possible profits. They become exuberant and turn to excessively risky business practices. But their customers are prone to moral hazard too. They realize that money invested on the financial markets benefits from central-bank support. Therefore they have a perverse incentive not to look too closely at the risks. They become exuberant as well.

Financial market fragility and moral hazard are therefore only proximate causes of financial crises. The ultimate cause is monetary policy, and in particular, the current paper-money system, which allows the central banks to provide limitless lender services. Monetary policy creates powerful incentives for market participants to reduce their equity ratios and thus increase the likelihood of contagion. The lower the average equity ratio, the smaller is the critical firm size that might entail contagion effects.

The foregoing considerations are perfectly straightforward. They are a hard pill to swallow, though, for true believers in the benefits of paper money and monetary policy.

Comments

"Common people might be less informed than their bankers about the technicalities of financial instruments and investment strategies, but they can read a bottom line. They can also compare bottom lines and abandon their agent if they feel other people might take better care of their money."

One can apply that passage to the context of our federal government in general, as well. The public in general may not be informed as to the process of how the Federal Reserve works, and how legislation is manipulated by lawyers to benefit themselves and bureaucrats' cronies, but they can read a bottom line, and they know when they are being screwed.

Everything we hear coming out of Washington is one reason after another to "abandon our agent" (the federal government, including its central bank), allow competing currencies, decentralize the banks, outlaw fractional reserve banking, enforce sound private contracts and throw fraudsters in jail, and return to freedom under the Rule of Law.

The law of nature is superior in obligation to any other. It is binding in all countries and at all times. No human laws are valid if opposed to this, and all which are binding derive their authority either directly or indirectly from it. ~ Institutes of American Law by John Bouvier, 1851, Part I, Title II, No. 9

[The natural] law is the paramount law, and the same law, over all the world, at all times, and for all peoples; and will be the same paramount and only law, at all times, and for all peoples, so long as man shall live upon the earth. ~ Natural Law or the Science of Justice by Lysander Spooner

The law is the organization of the natural right of lawful defense. It is the substitution of a common force for individual forces. And this common force is to do only what the individual forces have a natural and lawful right to do: to protect persons, liberties, and properties; to maintain the right of each, and to cause justice to reign over us all. ~ The Law by Frédéric Bastiat

However accurate you are in your analysis, you are missing one crucial point...Government sets the laws along with the Central Bank. In the case of the U.S., Government and the Federal Reserve sets the regulations on how all banks and lenders are to conduct business. As an employee of a Bank I can tell you that nothing, nothing is done at a local, regional or even national bank that isn't in line with Government regulation.

In the case of this recession and economic quagmire, it is at it's core a response to regulation. It is not "banking" that is responsible...it isn't even Central Banking...it is Government Banking.

Banks are forced to lend money at a higher risk. Banks are not allowed to make decisions on who or under what conditions they can lend money under. The Government sets those rules and Banks must follow or...not be Banks.

So, in the end, however we share the consequences of the risk of Banking...the greater risk is leaving it up to the Government and those who can manipulate the Government to decide what those regulations are. The Free Market is not in control...and neither is the "greedy" banker.

Good observation, usc, which brings up the question, "Where does government end and banking begin?" If the government controls all functional aspects of banking, are they two distinct entities or merely government masquerading as private enterprise?

The US also has "central health," wherein all doctors must go to government-approved education centers and earn government-approved degrees based on government-approved curricula. As is the case in banking, the central authority, the government, mandates how the profession operates.

So where does government end and healthcare begin? Since healthcare cannot exist independent of government regulation, isn't all healthcare government-run?

And education? And health insurance?

When these government systems inevitably break down, the politicians throw the blame at the "private institutions," and no one sees that the government ARE the "private institutions." And of course the solution is more governmental control, in a valiant attempt to reign in the cowboys and provide safety and stability to society.